Ginger plc and Scarlet plc operate in the maritime transport industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate annual earnings before interest and tax of 5m, and both companies as a matter of policy, distribute all residual profit as dividends. The companies capital structures are as follows:

Ginger plc	Market Value (m)
Equity: 40m ordinary shares of 1 each	40
Debt: 20m 5% Debentures	25
	65
Scarlet plc	Market Value (m)
Equity: 120m ordinary shares of 50p each	60

Required:

Calculate the maximum capital gain that could be gained by an arbitrageur holding 1% of the equity in Ginger plc, whilst maintaining that arbitrageurs income and exposure to risk;

(30%)

Explain how your scheme in (a) ensured that the arbitrageurs exposure to risk remained unchanged;

(30%)

Demonstrate that the arbitrageurs risk position is unchanged by considering a fall in pre-tax profit for both companies;

(20%)

Identify the assumptions upon which Modigliani and Miller based the 1958 version of their capital irrelevance principle.